How Maturing Secondary Transactions Took the Edge Off the ‘Zombie Apocalypse’

Three years ago, zombies were all the rage – and not just because that was a magical time before TV viewers had wearied of “The Walking Dead” …

The year 2015 saw widespread coverage in the private equity media of the potential problems of non-performing “zombie funds” – investment vehicles holding assets acquired before the 2008-10 downturn and unable to realize returns on those investments.

Concern was particularly acute that year because it marked the 7th anniversary of 2008-vintage funds. Reports indicated that as of July 2015, there were believed to be 1,180 zombie funds worldwide, all formed between 2003 and 2008 and holding more than 2,800 companies estimated to be worth $127 billion.

Those 2008 funds were seen as particular culprits, having put money to work at peak valuations just prior to the financial crisis only to see the value of their acquisitions plummet in the downturn. According to a Preqin dataset released in mid-2015, venture capital funds made up more than half of the estimated zombie funds in the population at that time.

The concern back then was that a prevalence of underperforming zombies could drag down the private equity market as a whole, threatening the fundraising capabilities of GPs and leaving LPs unable to rebalance their portfolios, with invested capital tied up in non-performing, “undead” funds.

Looking back, those concerns seemed largely unfounded. The private equity market has continued to boom, with robust valuations and 2015, 2016 and 2017 all standing as record fundraising years for North American and European private equity funds. If anything, the focus is less on the “zombies” of 2015 – these days, the challenge is to figure out which current-day investments are being made at the sort of top-of-market valuations that could make them part of the next wave of zombies.

It’s fairly well documented that valuation multiples have been increasing over and beyond pre-crisis levels. And, a continuing increase in M&A activity will most likely put further pressure on price multiples as is displayed below.

Secondary Transactions Have Taken the Bite Out of the Feared “Zombie Apocalypse”

One trend that has helped take some of the bite out of the feared “zombie apocalypse” has been the maturing of the private equity secondary market as an option for liquidity. These transactions can involve the direct sale of a fund’s entire remaining assets to a new investor or a GP-led tender offer in which existing LPs are given the option to sell to a secondary investor or stay in the fund, potentially under restructured terms or an extension of the fund life.

A third flavor of restructuring involves rolling over the entire fund into a new vehicle, with the same GP leadership and the backing of a secondary investor. Here, LPs also have the option to cash out or stay in.

GP Restructurings Take Center Stage

While discussed as far back as 2011, GP-led restructurings really began to pick up steam in 2016; the year 2017 saw secondary investor Lexington buy out $1.4 billion from LPs in a 2012 BC Partners fund through a transaction that also included a stapled commitment of $700 million to BC’s successor fund. That year also featured Warburg Pincus selling a $1.2 billion portfolio of Asian investments from a 2012 fund to a secondary investor.

In March 2018, Nordic Capital executed the largest-ever GP-led restructuring, selling nine companies with approximately $1.7 billion in net asset value held in a 2008-vintage fund to Coller Capital and Goldman Sachs Asset Management. LPs who rolled over their exposure into a new, five-year continuation fund with Coller and Goldman were given essentially the same terms as they had in the Nordic vehicle; about 40% of LPs by value chose to stay in. The deal was valued at approximately $3.1 billion in total.

Intermediate Capital Group (ICG), a leading global investor in the PE fund restructuring and secondaries market, announced this month that they were nearing the $1.6 billion target for their new fund ‘Strategic Equity Fund III’ after being in the market just eight months. ICG’s $1.1 billion second fund closed in the summer of 2017 ahead of the original target and was already 40% invested at the time of close.

ICG has been active in the secondaries market in 2018, backing the spinout of Aretex, a private equity team from the Chinese conglomerate ZZ Capital International, as well as the restructuring of a 2006-vintage central and eastern Europe-focused fund managed by ForeVest Capital Partners, a spinout of PineBridge Investments.

For the first half of 2018, GP-led secondary activity totaled approximately $7 billion – on pace to at least match the total from 2017 -- and represented a record 26% of secondary transaction volume.

Secondary transactions can be tricky from many different perspectives, with the result that LP approval is by no means guaranteed. Among the potential issues:

  • The GP often is involved in both ends of a fund recapitalization and has both a fiduciary obligation to LPs to maximize value in an existing fund and a motivation to lower the price paid for those assets by the new vehicle (whether because the GP is participating as a buyer or because the GP’s economics will be tied to the pricing of those assets);
  • While many LPs will want to sell, transaction costs and any fee paid to financial advisors for their work on the restructuring can be a sensitive subject and something many LPs will want to negotiate;
  • Some existing investors may be happy with the existing fund and may not want to roll into a new vehicle or go through the restructuring of their interest.

As with nearly every aspect of the evolving private equity marketplace, GP communication and transparency about fees, interests and pricing are essential in securing LP approval of secondary transactions. Nearly all observers of the new wave of restructurings point to the need to secure an independent, third-party valuation of the assets being restructured, removing questions about mark-to-market valuations that are tied to an outdated investment thesis.

We have written extensively in past blog posts and white papers about the way in which this decade’s institutionalization of the private equity market has reshaped GP and LP behavior. While secondary transactions remain a relatively new frontier in private equity, it seems logical to anticipate that the current surge in activity will result in new learnings that will generate best practices governing how the industry will handle the next generation of zombies – coming your way sometime in the 2020s!